Junk Bonds Hit A Speed Bump; Time To Sell ETFs?

By Michael Aneiro

High yield bonds are stuck in a bit of a rut. The market’s has posted a a 0.67% loss over the past month and its average yield is up half a percentage point during that time to 5.37% after falling to an all-time low in June. High yield funds also saw a steep $1.67 billion net outflow last week.

What gives? Things aren’t exactly terrible – the market’s still up 4.93% year to date, and defaults aren’t a problem – but the latest geopolitical worries highlight how risky investments can get dinged during flights to safety. Today Michael Contopoulos, high yield credit strategist at Bank of America Merrill Lynch takes the market’s temperature and says investors shouldn’t worry too much:

We believe the main reason for the recent high yield selloff is negative publicity and concerns permeating the retail community. What started as dealers repositioning given historically low yields has led to an exodus by retail investors as the comments from the Fed and media outlets have negatively impacted high yield valuations. We review today’s high yield landscape from a rate/volatility, default, geopolitical and valuation perspective and conclude that the market remains in good shape. As such, we continue to believe bond returns will approach 7-8% in 2014, though also prefer to sit on the sidelines and wait out the current weakness a bit longer having taken down our high yield exposure at the recent tights.

Contopoulos notes that high-yield dealer inventory fell sharply early this month, and that exchange-traded funds saw the biggest share of last week’s fund outflows, which followed comments from the Fed suggesting “signs of excess” in leveraged lending:

It is comments such as these that may have led retail investors away from high yield and into high grade… a move that we think may leave investors exposed once rates begin to rise…. [W]ith defaults remaining low for the foreseeable future, the demand for fixed income to remain high given an ever increasing baby boomer population, and low yields globally, we believe high yield bonds represent a sound investment within the corporate credit space.

But Neil Leeson and Wenbo Zhou of Ned Davis Research today look at high yield ETFs – namely the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and the SPDR Barclays Capital High Yield Bond ETF (JNK) – and say it might be a good time to sell:

[I]nvestors are no longer being compensated for the additional risk in high yield bonds… [B]oth HYG and JNK now trade at a premium to the underling NAV of the bonds that make up the fund. Historically, neither of these two funds does well when trading at a premium. The funds have typically depreciated, not appreciated, over the next one to three months. Investors should consider reducing their domestic high yield bond ETF positions and look to re-establish their positions once spread premiums become attractive again.

Amey Stone is Barron’s Income Investing blogger and Current Yield columnist. She was formerly a managing editor at CBS MoneyWatch, MSN Money and AOL DailyFinance. Her responsibilities included overseeing market coverage and personal finance topics. Prior to those roles, she was a senior writer at BusinessWeek where she authored the Street Wise column online and contributed to the magazine’s Inside Wall Street column. Topics covered included economics, corporate finance, Fed policy, municipal bonds, mutual funds and dividend investing. She co-authored King of Capital, a biography of Citigroup Chairman Sandy Weill. She is a graduate of Yale University and Columbia University’s Graduate School of Journalism.